How Stock Options Lead to Scandal

This Times editorial is right about the need for honest accounting with regards to stock options. But it fails to appreciate the bias thats built into the tax code to use stock options for compensation.

[quote]MILLBROOK, N.Y. - In his speech about corporate fraud and abuse, President Bush mentioned stock options only once - and then to endorse an existing proposal to require shareholder approval of all options plans. His endorsement is welcome, but it is woefully inadequate: the stock-options culture is at the root of the current scandals on Wall Street.

Options, which are not counted as an expense and thus inflate earnings, bring with them a powerful incentive to cheat. They hold out the promise of wealth beyond imagining. All it takes is a set of books good enough to send a stock price soaring, if only for a while. If real earnings are not there, they can be manufactured - for long enough, in any case, for executives to cash out. This, in essence, is what happened at Enron, WorldCom, Xerox - indeed, at quite a long list of companies. That list is bound to grow, judging by the findings of a study I published with two colleagues last year.

We examined operating earnings - profits from ongoing operations excluding nonrecurring items like sales of assets - of firms in the Standard & Poor's 500 index. In comparing these earnings to net income (a company's total profits, including one-time gains or losses and other nonrecurring charges), we found that operating earnings have exceeded net income every year for 20 years.

This is counterintuitive. Especially during the go-go years of the 1990's, companies often boosted their net income compared to their operating earnings by selling valuable assets - a subsidiary, for example, that had been bought years earlier at a low price. The implication is clear: in many instances, corporations recast operating expenses as nonrecurring charges and, to a lesser extent, recast nonrecurring income as operating revenue...<hr></blockquote>